COLLAPSING EXCHANGE-RATE REGIMES - SHOCKS AND BIASES

Patterns in domestic credit creation stemming from inconsistent fiscal policies have received widespread attention for their role in aggrevating speculative attacks on central bank foreign exchange reserves and contributing to the collapse of exchange rate regimes. This paper acknowledges the importance of monetary and fiscal discipline, but also emphasizes the importance of other random shocks to the domestic money market, most notably shocks from external credit supplies and relative prices. Policies of the domestic fiscal authorities are only partial catalysts for speculative attacks on a currency. Expansion of domestic credit stemming from the monetization of fiscal imbalances may be dominated by involuntary domestic credit expansions which are necessitated by surprise shortages in supplies of external capital. Further, the unexpected availability of external capital translates into a lower net critical reserve floor, making the depletion of central bank reserves by a speculative attack more difficult to accomplish. Relative price shocks also randomize the demand for nominal money balances and therefore may also have a strong direct influence on the probability of an exchange regime collapse. Empirical studies of exchange rate crises that neglect these considerations will produce biased estimates of both expected collapse probabilities and anticipated post-collapse exchange rates. © 1991.